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Evaluating the specification errors of asset pricing models

  • Hodrick, Robert J.
  • Zhang, Xiaoyan

This paper examines the specification errors of several asset pricing models using the methodology of Hansen and Jagannathan (1997) and a common data set. The models are the CAPM, the Consumption CAPM, the Jagannathan and Wang (1996) conditional CAPM, the Campbell (1996) dynamic asset pricing model, the Cochrane (1996) production-based model, and the Fama-French (1993) three-factor and five-factor models. We use returns on the Fama-French twenty-five portfolios sorted by size and book-to-market ratio and the risk-free rate as our test assets. The sample is 1952 to 1997. We allow the parameters of the models' pricing kernels to fluctuate with the business cycle which we measure in two ways. One uses the Hodrick-Prescott (1997) filter applied to either industrial production for monthly models or real GNP for quarterly models. The second approach for quarterly models uses the consumption-wealth measure developed by Lettau and Ludvigson (1999). While we cannot reject correct pricing for Campbell's model, a stability test indicates that the parameters may not be stable. None of the models correctly prices returns that are scaled by the term premium.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 62 (2001)
Issue (Month): 2 (November)
Pages: 327-376

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Handle: RePEc:eee:jfinec:v:62:y:2001:i:2:p:327-376
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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  1. Martin Lettau & Sydney Ludvigson, 1999. "Resurrecting the (C)CAPM: a cross-sectional test when risk premia are time-varying," Staff Reports 93, Federal Reserve Bank of New York.
  2. Sydney Ludvigson & Martin Lettau, 1999. "Consumption, aggregate wealth and expected stock returns," Staff Reports 77, Federal Reserve Bank of New York.
  3. Lars Peter Hansen & Ravi Jagannathan, 1994. "Assessing Specification Errors in Stochastic Discount Factor Models," NBER Technical Working Papers 0153, National Bureau of Economic Research, Inc.
  4. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  5. Daniel, Kent & Titman, Sheridan, 1997. " Evidence on the Characteristics of Cross Sectional Variation in Stock Returns," Journal of Finance, American Finance Association, vol. 52(1), pages 1-33, March.
  6. Donald W.K. Andrews, 1990. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Cowles Foundation Discussion Papers 943, Cowles Foundation for Research in Economics, Yale University.
  7. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
  8. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  9. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
  10. Campbell, John & Cochrane, John, 2000. "Explaining the Poor Performance of Consumption-Based Asset Pricing Models," Scholarly Articles 3163265, Harvard University Department of Economics.
  11. Robert J. Hodrick & Edward Prescott, 1981. "Post-War U.S. Business Cycles: An Empirical Investigation," Discussion Papers 451, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  12. Brennan, Michael J. & Chordia, Tarun & Subrahmanyam, Avanidhar, 1998. "Alternative factor specifications, security characteristics, and the cross-section of expected stock returns," Journal of Financial Economics, Elsevier, vol. 49(3), pages 345-373, September.
  13. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
  14. John Y. Campbell, 1992. "Intertemporal Asset Pricing Without Consumption Data," NBER Working Papers 3989, National Bureau of Economic Research, Inc.
  15. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
  16. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
  17. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  18. Loughran, Tim, 1997. "Book-to-Market across Firm Size, Exchange, and Seasonality: Is There an Effect?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(03), pages 249-268, September.
  19. Ravi Jagannathan & Zhenyu Wang, 1996. "The conditional CAPM and the cross-section of expected returns," Staff Report 208, Federal Reserve Bank of Minneapolis.
  20. Cochrane, John H, 1996. "A Cross-Sectional Test of an Investment-Based Asset Pricing Model," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 572-621, June.
  21. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, vol. 64(6), pages 1439-67, November.
  22. Wayne E. Ferson & Campbell R. Harvey, 1999. "Conditioning Variables and the Cross-Section of Stock Returns," NBER Working Papers 7009, National Bureau of Economic Research, Inc.
  23. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  24. Roll, Richard, 1977. "A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory," Journal of Financial Economics, Elsevier, vol. 4(2), pages 129-176, March.
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